Saturday, September 03, 2011
7:15:05 PM EDT

Worst September Since 1974

by
Jim Brown

It may be early to start calling September the worst month but the first two days of trading have been the worst September start since 1974.

Market Statistics

The market was inching lower before the open on worries out of Europe but the jobs report kicked it right off the cliff. Payroll employment crashed to a halt in August with ZERO new net jobs added. Even worse the prior two months were revised lower by -58,000. The July gains of +117,000 were too good to believe at the time and they were revised down to +85,000. The June gain of 46,000 was revised down to only +20,000. Estimates of the 86 economists surveyed by Bloomberg for August payrolls ranged from a decline of 20,000 to a 160,000 increase.

New private payrolls in July were revised up to +156,000 but government job cuts were revised up from -37,000 to -71,000 to offset those private payroll gains.

In August the private sector added +17,000 jobs, a significant decline from the +156,000 in July, but government job cuts of -17,000 cut the net number of new jobs to zero.

There are some qualifications. The BLS said the Verizon strike, which kept 45,000 workers on the picket lines, had a significant impact on job losses. Those workers went back to work during the last week of August and after the survey period for this report. That means some portion of those 45,000 were counted as losses in August and they will be counted as new jobs in September. Personally I don't think they should be counted on either side since they were just on strike but they did not ask me.

Also positive was an increase of 331,000 jobs in the Household Survey. This is a different survey than the nonfarm survey and this is where they get the unemployment rate, which remained flat at 9.1%. That rises to 16.2% (25.4 million) if you count everyone who have run out of unemployment insurance benefits and fallen off the official government rolls. That is another pet peeve of mine. Why drop people from the unemployed list just because their benefits expired? Answer, because it makes the unemployment number look better and keeps politicians in office. That means politicians can claim unemployment is only X% when it is really Y% and the general public does not know the difference. The official unemployment rate is now expected to remain at 9% for the rest of the year and decline to only 8.8% in the first half of 2012. Some analysts believe it will remain at least 9% for all of 2012.

It takes the creation of 150,000 new jobs each month to stay even with new workers joining the workforce. In fact 366,000 people joined the workforce in August. The monthly pace of job creation for the rest of the year is expected to remain at 100,000 or less even if we don't return to a recession.

I would take bets today that the August number is revised to a loss when the September report is released. Maybe it is the conspiracy theorist in me but to have a report saying the economy lost jobs on the Friday before a presidential speech on jobs might have been seen as politically damaging. A revision a month later to jobs lost is normally ignored. Time will tell.

Nonfarm Payroll Chart

In reality when you consider the setup for August with the debt debacle in full swing and the threat of default being blasted across the airwaves every day there was no incentive for employers to hire. Even after the debt deal was done we had S&P downgrade the U.S. credit rating and the equity markets were in freefall. That is not exactly a positive business environment. I am surprised we did not see a headline number with job losses instead no gain.

The president will speak on Thursday evening and offer proposals for putting Americans back to work. This could be the defining moment of his reelection campaign. His disapproval rating rose to 52% last week and there is a near zero chance of passing any stimulus or spending program in the current political environment. He will have to come up with some plan that does not involve spending and that is extremely hard for any president to do. The government, any government, can only directly create jobs by spending and those are only temporary, as we have seen from the sharp declines in government workers since the 2009 stimulus programs expired. Real job creation only comes from business and that is where any new programs will have to be focused. Job credits for new hires, tax credits for repatriation of jobs, payroll tax cuts for employers and reduced regulations are some of the programs tried in the past. A recent survey showed that 48% of businesses were considering trimming their workforce as a result of new regulations including the healthcare bill. If 48% of businesses are cutting back it will be very hard to add net new jobs going forward.

I believe the business climate improved in the latter half of the month when the world did not come to an end on the ratings downgrade. That downgrade has now been forgotten and we should return to some semblance of normal at least until the gang of 12 present their recommendations for another $1.5 trillion in spending cuts. That could start the political battles again and resurrect the story in the daily press.

Lost in the frantic coverage of the nonfarm payrolls was positive news in the Monster Employment Index for August. The index rose +3 points to 147 thanks to increased job openings in natural resources, healthcare and retail trade. On a year ago basis help wanted activity is up +8% compared to a +4% increase in July. Mining, transportation and other service businesses saw help wanted ads increase +20% since last August. Ads in New England increased by +3.2% and +3.5% for the Pacific region. An increase in ads for manufacturing, retail and professional services late in the month suggest the jobs climate was actually better than what the nonfarm payroll report showed. The headline number is now at the highest level since early 2008 after dipping to a seven year low at 114 in July 2009.

The economic calendar for next week is very light. The ISM Services on Tuesday is expected to decline slightly to 52.0 from 52.7. The Fed Beige Book reports is on Wednesday and it is the most important report of the week. This is the report that shows the economic activity in each of the Fed districts. In the July report economic activity was still growing at a moderate pace in most of the districts but there were some cracks beginning to show. This was to some extent due to the rising intensity of the debate over the debt limit. The report also detailed continuing weakness from the impact of the Japan earthquake on the supply chain. Both of those factors should have moderated by late August. However, the report does cross calendar month boundaries with the last half of July and first half of August represented in the report we get this week. Unfortunately that means the majority of the survey period was the most intense portion of the debt debate and the ratings downgrade.

Economic Calendar

The biggest problem for next week will come from Europe. Italy's Premier, Silvio Berlusconi, was criticized by the ECB and even the Vatican over weakening of the planned austerity measures. Berlusconi's coalition has been waffling on the plan and changing it almost daily to placate various groups. The ECB said the $65.8 billion package of spending cuts and tax increases was of "extreme importance" and urged Italy to follow through on its promise to pass it. The package was supposed to be sent to parliament for a vote next week but almost nobody believes it will happen as promised.

Italy is too large for the current 440 billion euro rescue fund and finance ministers are afraid the failure to follow through on the initial austerity package will send Italy spiraling out of control and the EU will have to put up even more money to solve the problem. Italy's debt is 120% of GDP and the second highest in the EU after Greece.

The ECB President Jean-Claude Trichet warned Italy again on Saturday when speaking at a finance conference. He urged Berlusconi's government to "fully confirm and implement" the austerity as initially planned in order to "reinforce the quality and the credibility of the Italian strategy and its credit worthiness."

The Greek austerity review by the EU commission was halted last week along with talks about future bailout payments. Inspectors for the IMF, EU Commission and the ECB, known as the troika, had been in Athens to check on the pace of compliance. The troika halted the inspections and talks for a ten-day cooling off period after tensions reached a fever pitch. The troika found that promised austerity measures were slipping farther behind and the budget deficit for 2011 was growing. Reportedly the troika had asked to see the 2012 draft budget but were refused with Greek officials saying it had not been completed yet. When they would not even disclose the draft under discussion the troika members left Greece.

Currently Greece is depending on two bailout loans of $157 billion from May 2010 and another $155 billion that was agreed on in June 2011. The funds are being released in small increments as stages in the austerity program are completed. The troika claim Greece is dragging its feet and failing to follow through on many of the conditions for payment. The troika released a report on Wednesday warning Greece would likely miss its 2011 budget targets because of months of austerity delays by the government and lax tax collection. Avoiding taxes is an art form in Greece.

On Saturday further news broke with a senior IMF official saying they expect a "hard default definitely before March, possibly this year, and it could come with this current program review. The chances for a continued bailout are slim." Separately, senior German FDP official Otto Solms, a VP of the Bundestag and an economic committee member in parliament said, "since Greece could not handle its debt problem it should consider leaving the euro. It should be considered whether a restructuring and exit from the euro would offer better perspectives for the euro currency union and Greece itself. Taxpayers in Northern Europe and especially Germany cannot accept inability or reluctance." This was in response to a Greek official saying on Saturday they would not consider any further austerity.

Germany was supposed to vote on the new EFSF rescue fund next week and on the constitutionality of the bailouts in general. Recent comments from various sources suggested the vote was in trouble. Late last week a spokesman for Merkel's conservative party said the vote could be pushed back until the 29th -30th because of a visit by the pope. The pontiff is scheduled to speak to parliament on the 22nd. Analysts believe the delay is to shore up support for the vote. This is just another challenge for the EFSF and the EU bailouts in general but at least a failed German vote should not cause market trouble next week.

The entire EU debt crisis is quickly getting worse. It is eventually going to blow up with very damaging consequences. The bond market has already factored in a debt default by Greece despite the continuing bailout funds. They don't believe Greece will pay those back either. For instance the one-year treasury note now has a yield of 72.05%. It rose by more than 10% on Friday alone. That is a 1,000 basis point move. In bond terms that is gigantic. The two-year note is not much better at 49.6%. Greece is going to default. It is only a matter of time and that will be a serious crisis for the EU banking system. If Greece leaves the EU and banks take a hit the two with the most risk are CS and UBS. Shorts anyone?

The U.S. jobs report and the worries over Europe pushed gold up once again. The magnitude of the moves is simply amazing. On Friday gold gained more than $57 to close at $1,878.50 before rising to 1886.70 in after hours trading. The -$200 point decline from two weeks ago has been almost completely erased. This rally came despite a four-day rise in the dollar to a two week high.

Gold Chart

U.S. treasuries were the safe haven of choice last week. The ten-year note closed with a yield of 1.996% and the lowest closing yield since the 1950s. Talk about safe haven! The 30-year yields closed at a two-year low but still above the yields seen during the recession.

Ten Year Yield Chart

30-Year Bond Yield Chart

The drop in yields on the five and ten year notes is in anticipation of the Fed coming back into the market in a new program to lengthen the term of the securities they are currently holding. Currently the Fed bought short-term securities in the QE2 program and they are continuing to buy the short term paper as securities in their portfolio mature and roll off. After Friday's jobs report the Fed is expected to begin a new program called operation Twist. This was first done in the 1960s under JFK and named the Twist after the Chubby Checker record at the time. Basically the Fed twists its portfolio out of short term notes and into longer term durations like the five and ten year notes. This forces down yields on the longer end of the curve and implies that rates will continue low for years into the future. Analysts believe it will have only a marginal impact on the economy but the Fed is running out of bullets or as Dr Doom says, "There are no rabbits left in the Fed hat." The Fed is likely to announce the new program on or before the Sept 20th FOMC meeting.

Also weighing on the markets on Friday was news the Federal Housing Financial Authority (FHFA) was suing 17 financial firms for more than $200 billion in mortgages that turned toxic when the housing boom collapsed. Bank America is being sued for losses on $57.5 billion in mortgages originated by Bank America, Countrywide Financial and Merrill Lynch. Merrill's portion is $24.8 billion, BAC $6B and Countrywide $26.7B. JP Morgan was the second highest at $33B and Royal Bank of Scotland at $30.4 billion. Barclay's (BCS) was sued for $4.9B, Deutsche Bank $14.2B and Nomura $2B. Others sued were Citigroup, Ally Financial, First Horizon, General Electric, HSBC, Morgan Stanley, Goldman Sachs and Societe Generale. Several banks commented on the suits and the general response was something like, "the government's claims are without merit and we intend to defend ourselves vigorously." Of course that is the standard answer whenever someone is sued.

However, When you look at the legal firepower that can be brought to bear by that list of companies you have to think the government better have a very good case. Unfortunately we know from past history the government does not even have to have a case in order to win. They have unlimited funds, unlimited time and they are not motivated by a profit motive. They can continue fighting the case forever or until the other party runs out of money or simply gives up. This is a fishing expedition by the FHFA and the best thing the banks can do is throw up a solid first defense with thousands of pages of legal precedent and then try to settle before it actually gets into the courts.

BAC lost -8%, GS -4%, MS -6%, DB -6%, CS -4%, BCS -8% and RBS -5%.

The administration is doing everything it can to create jobs and get banks to lend money. At the same time the FHFA is doing its best to crash the system. Analyst Richard Bove said on Bloomberg "if you make the assumption over the next few years, all of these suits are going to move forward and they are all going to be won, you are going to wipe out the American banking industry and you are going to wipe out the American economy." The government already claims the banks are under capitalized and under Basel III they have to raise additional capital. If the suits cost them another $100-$200 billion in capital that simply means the banks will have to lower costs even further and they do that by laying off workers, closing branches and cutting back on loans. Instead of helping businesses expand they hurt businesses by reducing credit lines and calling in loans. They will make fewer mortgage loans and home sales will suffer. By default they will be increasing unemployment and pushing us closer to a recession.

The FHFA is claiming the banks packaged loans with subprime credits and did not tell Fannie and Freddie. DUH! Fannie and Freddie are the ones that set the rules on what they would buy. Fannie and Freddie ARE the mortgage market in the USA. They write the rules and the mortgage originators create mortgages that conform to those rules. Were there errors and omissions? Undoubtedly. Were there subprime credits? Absolutely but they fit the rules laid out by Fannie and Freddie. Those two lenders had a fiduciary responsibility to underwrite any loan portfolio they purchased and resold. What this suit means is that Fannie and Freddie did not do their underwriting in advance and if they did they did it badly. That is not a reason to come back later and sue the banks.

I get it. I understand their frustration with the billions in loan losses they eventually took. I should probably say losses we the taxpayer took since the government bailed them out with $140 billion so far. However, the lawsuits have to end somewhere. This is ridiculous at this point in the game to launch a new round of "let's beat the bankers." The banks fund the economic growth. We know from playing monopoly if you run out of money you can't build buildings or buy inventory. This is just another example of government stupidity. You can't sue your way to economic growth.

Many of these banks have already taken tens of billions in write-downs and charge offs on the subprime loans. Many have already been sued by various agencies and groups for tens of billions more. Bank America has a $20 billion settlement in process and another one for $12.9 billion. On Thursday the Fed asked BAC to come up with a contingency plan just in case economic conditions worsened. That should be a clue as to what the Fed is thinking. Add in Friday's suits and conditions just worsened.

On a side note you may remember from the many references in the subprime crisis that New York governor Andrew Cuomo was U.S. Secretary of Housing and Urban Development from 2004-2007. His memos instructing Fannie and Freddie to lower their credit guidelines and accept the subprime loans in order to promote home ownership in the USA were the reasons those agencies became so heavily involved in subprime mortgage securitization. When they were buying the loans the home values were going up 20% a year and everybody was making their payments. When the bust came in 2008 it turned out to be the Great Recession. You should not be able to sue banks in 2011 for loans you bought in 2006-2007 that defaulted in 2009. That is like a person buying a Suburban in 2006 when gas was $2.50 and then suing GM for their money back in 2008 because gas was $4.50. You knew gas could go up but you bought it anyway. It was not GM's fault.

The drop in jobs caused serious knee jerk reactions in almost every sector. Energy was no exception. Crude prices declined more than $3 at one point because a lack of jobs and a potential recession is negative for demand. At least that is the theory. I believe it was profit taking on anything with a recent rally. Crude was up +$10 in the last two weeks so it was a way to capture profits and raise cash to cover margin calls on imploding stocks.

Crude had more bullish fundamentals on Friday than any other time in recent weeks. Tropical storm Lee picked up speed just as it hit the oil patch in the Gulf and almost 60% of Gulf production from nearly 3,000 rigs and platforms was shut in along with 55% of gas production. 237 platforms and 23 drilling rigs were evacuated. There are 617 manned platforms and 70 drilling rigs operating in the Gulf. The storm does not have strong winds at only 45 mph but it is packing expected rain of 14-20 inches. Because rig operators did not know how quickly Lee would accelerate or to what level they had to err on the side of caution and evacuate many of their installations. This will cause a decline in crude inventories over the next couple weeks but no material damage is expected to the production platforms.

Crude Oil Chart

Just to prove it was a bout of knee jerk profit taking the Brent contract fell over $2 and nothing in the U.S. jobs report would impact short-term demand in Europe. There is still an ongoing shortage of light crude in Europe of roughly 600,000 bpd that is being made up by drawing down existing inventories. There was no specific reason for Brent to decline.

Brent Crude Chart

Gulf Storm Chart

Next weekend is going to be a problem for the eastern seaboard. Hurricane Katia is slowly moving closer to the mainland and should reach the Carolinas on Saturday. It is currently a category one storm but is expected to strengthen as it moves over warmer water. The storm is still to far out to predict landfall but the direction has not changed in a week. The normal directional change from here would be a turn to the north to follow Irene's path.

Hurricane Katia

Markets sold off sharply in August with the MCSI All Country World Index down -7.5% and the biggest loss since May 2010. Short bets on the S&P rose to 3.03% of all shares outstanding on August 29th. This was up from up from 2.7% at the beginning of August and the highest level since November. The recent high was 5.52% in August 2008 just before the recession crash.

Some analysts are already ratcheting up expectations for another dip below 1100 on the S&P sometime in September. They believe that even if the U.S. economy struggles through we are going to see Europe hit a wall on the sovereign debt problem and European banks are going to take significant losses. That will also hurt U.S. banks indirectly as the counter party transaction problem comes back to haunt us.

The Dow has already declined -373 points in September to make this the worst start since 1974. The S&P rallied +9.8% from the 1121 low on Aug-22nd and the high at 1230 on Aug-31st. A nearly 10% rally was due for a decent bout of profit taking. The jobs data and impending holiday weekend became the perfect opportunity. Stops were hit and the market collapsed on very low volume.

I wrote on Thursday that all the trading would be in the first hour and the market would be dormant the rest of the day. That is exactly what happened. The market gapped lower from 11,496 to 11,244 in the first 15 minutes and we closed the day at 11,241. Everybody exited at the open either by choice or by getting stopped out and then they went home. Volume was light at 6.9 billion shares.

Some market reporters were complaining there was no dip buying in the afternoon. When you think about it very few traders were either a) actually trading after 10:AM or b) were stupid enough to go long ahead of a three day weekend with Europe in meltdown mode.

The U.S. just got the worst economic data in months and declined -250 points. You know Europe and Asia are going to follow our lead and trade down on Monday while our markets are closed. With Germany, Greece, Italy, the IMF and the ECB all in a daily spitting contest there is a good chance Europe could trade down on Tuesday as well and that could produce an ugly open for the U.S. on Tuesday. That is not the kind of scenario a U.S. trader would want to buy on Friday afternoon.

The S&P rallied +9.8% since the Aug 22nd lows and then declined -4.5% since the August 31st highs. That is close enough to a 50% retracement in my book that we could be looking for a bounce. Obviously that depends on what happens overseas on Mon/Tue and on how much play the bank suit gets in the press but technically it might be an opportunity. In a perfect world I would like to see a dip down to 1160 at the open on Tuesday and then a rebound back over 1185. That is probably too much to ask for in one day in this environment so I will be happy with a dip to 1160 and at least some indication of dip buying. If the FHFA bank suit news gains speed and begins to develop a life of its own then a dip to 1120 could be in the cards. That would erase the entire August rebound.

S&P Chart - 90 Min

The Dow slipped below initial support at 11,325 and could see a further dip to 11,100 or even 11,000 on Tuesday. Obviously we would like to see it bounce at 11,100 because weakness below that level could take us all the way back to 10,800. A break below 10,800 could achieve terminal velocity with the next stop at 10,000.

Predicting a landing point with the Dow moving 300-400 points a day is impossible. We have to watch for the decline to end and then nibble at the edges. We don't want to catch this falling knife.

Dow Chart

Tech stocks were weak with the overall market but they were also reacting to the third consecutive month of declines in semiconductor billings. The semiconductor index declined -2.4% to initial support at 340. Networkers were also weak. Google and Apple held up relatively well with declines of only about 1.5%.

The Nasdaq closed right on initial support at 2480 and any further weakness could test 2400. In theory the Nasdaq has minimal exposure to banks but when the tide goes out all ships settle lower.

Nasdaq Chart

Odds are good the Russell will test support at 675 or even 650 if the market weakness continues. Small caps have declined faster, -3.6% Friday alone, and will continue to do so if the economics worsen. If the economy is going to weaken the small caps will be dumped first and blue chips last.

Russell Chart

There is a lot of noise in the market with various components in Europe competing for headlines every morning along with multiple challenges, both political and economic, in the USA. However, what we are not hearing are problems in U.S. corporations. Earnings warnings are minimal and companies are announcing stock buybacks again. Insiders are buying stock and earnings guidance is holding. There may be signs of economic weakness in the reports but the company guidance is still positive. Sure there are some outliers but even if the economy was growing at 5% there would still be companies failing to execute properly.

I read a guidance report for WABCO (WBC), a global supplier to the commercial vehicle industry, and they were very positive about order growth all over the world including North America. "Currently, we see no sign of a slowdown in our markets globally and we feel confident about our previously communicated guidance for 2011." (WBC Guidance) Are they the outlier or are they the norm?

We could be just experiencing an economic hangover from the debt debacle and the ratings downgrade. If so it will pass once the brain fog clears. The Fed is almost sure to increase stimulus on the 20th. It is a good bet traders will act on that starting sometime next week. That puts me in the "buy the dip" camp for next week. I might not jump in at the open on Tuesday but I would look for a bounce from support on Tue/Wed as a signal to start a couple positions.